Summary

August was tale of two halves:

• The first 10 days saw heavy buying interest driven by strong corporate earnings, softer crude prices, gradual improvement in the monsoon, a policy rate hike by the Reserve Bank of India (RBI) and supportive global cues coming from US and China.
• However very soon, the evolving debt crises in Turkey & Argentina bled into other emerging markets currencies, including the Indian rupee (INR). This was further exacerbated by a sharp rally in crude prices, the US Federal Reserve sticking to their gradual approach of raising rates and the US unrelenting on trade wars with Canada and China. These developments triggered heavy selling across all markets; equity, debt and currency.
• Risk markets are now stuck between bottom-up growth inflation dynamics pointing to an investment case for healthy long term returns, versus the short term risks coming from emerging markets (EM) currency meltdown and its implication on liquidity conditions, inflation and the potential derating of multiples as risks to growth are highlighted.

Market

The month started on a positive note with RBI increasing the policy repo rate by 25bps to 6.5%, which was expected. The RBI also maintained a “Neutral” policy level which was well received. This signal of a prolonged pause in policy rate and the expansion in real policy rates to RBI’s desired level of 150-175 bps, led to a rally in yields, approaching the lows of the month.

This stance was further validated by July’s inflation readings, with better than expected moderation. The Consumer price index (CPI) dropped to 4.2% versus a consensus of 4.5% and was also down from 4.9% in the prior month. This drop was led by broad-based easing in food price and core inflation.

FY19’s first quarter GDP data also surprised positively, by accelerating to 8.2%, versus 7.7% in 4QFY18. Real gross value added (GVA) picked up to 8% from 7.6% growth in 4QFY18, largely led by the agriculture and industrial sectors. On the demand side, private consumption surged by 8.6% while fixed capital formation (GFCF) grew at 10%.

However, the external headwinds turned out to be a bigger influence, despite the improving bottom up growth inflation dynamics. The EM contagion risk dragged down the INR by 3.3% in August. This was exacerbated by a sharp 10.4% rise in dated Brent crude prices, after softening by 4.1% in first half of the month. Should these trends persist in near term, these factors might feed into pressure on 2 fronts.

• Liquidity impact: India’s external debt as at 31 March 2018 was $530 bn. The lion share of this debt is denominated in US dollar Indian rupee terms, 49.5% and 35.8% respectively. Commercial borrowings at 38.2% account for the largest share, followed by non-resident Indian deposits at 23.8%, Sovereign debt at 21%, and short term credit at 19%. The short term credit is largely trade credit backed by receivables. Hence the material stress (if any) will largely be seen in commercial borrowings.
• Impact on inflation: a 5% INR depreciation impacts CPI by 40-50bps. We have so far maintained the view that RBI is done with the rate hikes for the year. However, if the current pace of depreciation in INR continues through the next couple of weeks, we would not rule out an additional 25 bps rate hike at the next policy meeting. A stronger economic growth forecast might also bolster the case for a further rate hike.

Performance

Despite an 18bps rise in yields on the benchmark ten-year Government of India bond in August. This was however offset by a 9bps contraction in spreads on (AAA)-rated ten year corporates. That net spread move combined with the beneficial impact of high income coupons drove a modest 0.06% gain in the Fund’s net asset value (NAV) in INR terms.

However, the currency depreciated sharply, by 3.30% against US dollar this month, dragging the NAV to a loss of 3.2% in USD terms. Year to date the Fund’s NAV is up 1.28% in INR; but down 8.9% in US dollar terms, dragged down by a 10% rupee-dollar depreciation.

Strategy

The Fund had prudently reduced its duration risk earlier in the year. We have decided to stick to the strategy of prudence given the uncertainty in oil markets, the risk of escalation of the trade (and currency) wars and political uncertainty ahead of next year’s general elections in India. The weakness in the INR-USD is, in our opinion, meaningfully overdone, and we expect a rebound, but the timing will be dependent on the resolution of some of these macro issues impacting EM.